Investors worried about sinking Treasury values can breathe easier—for now. New banking regulations mean sovereign debt will look a lot more attractive in the short term. After that, things could turn ugly.

What comes after QE2?

Who will pick up the slack after the Federal Reserve ends its second program of quantitative easing, at the end of June, and stops buying $75 billion in US Treasuries every month? Not exactly a minor question for a country running a national debt of $14.5 trillion.

The answer, investors fear, is no one. That would lead to an increase in US interest rates—if the market found buyers at all, they would ask for a higher yield—just when the US economy is slowing.

The worst-case scenario would be that some delay in raising the debt ceiling would create a technical default—at precisely the time the Fed exits the Treasury market.

That could lead to a spike in US interest rates, rather than a more gradual increase. A spike would doom any chance for a recovery in the housing market, and lead to massive losses for anyone holding a portfolio of Treasuries.

At least that’s how the worry goes.

I’ve been racking my brain to find another answer.

I think QE3 is off the table. The Federal Reserve isn’t about to take on the financial and political risks of adding a half-trillion or so to its balance sheet, which has climbed to $2.84 trillion as a result of the central bank’s battle against the effects of the global financial crisis.

But recent decisions by regulators drawing up the new Basel III rules for the global banking system point me to a new alternative to the disaster scenario prophesied for the Treasury market.

Basel III Will Ride to the Rescue
Yep, I’m referring to the bank regulation scheme more complicated than Ptolemy’s astronomy—and much less likely to work as predicted.

I don’t know that I’d call Basel III a rescue plan for the developed world’s central banks—the Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank—because I don’t know if the regulators (including central bankers) who put together the rules intended to rescue central banks. The rescue may just be an unintended consequence of the new regulations.

Intended or not, plan or side effect, Basel III does promise to “solve” central banks' big balance sheet problems—for a few years anyway.

Let me show you how this is likely to work, and then run through some of the dangers that this “solution” creates.

Basel III, the aptly named successor to Basel II, is an attempt to make the global banking system less susceptible to a replay of the global financial crisis that took Lehman Brothers and Bear Stearns into bankruptcy, threatened to take down American International Group (AIG), (C), and a Citigroup handful of European banks, and almost led to the collapse of the world’s financial system.

As part of that solution, banks will be required to show a higher Tier 1 capital, or core capital ratio, than before the crisis. The theory is that banks with more capital will have bigger cushions to fall back on in the event of a future crisis.

The core capital ratio under Basel II was set at 4%. Under Basel III, the base core capital ratio will climb to 7%.

The rules also set up capital surcharges for the 30 banks in the world that regulators have deemed "systemically important" to the global system as a whole. These banks have been divided into categories, with surcharges beginning at 1 percentage point and climbing to 2.5 percentage points. There’s even an empty category with a 3-percentage-point surcharge for banks that in the future exceed today’s top-tier banks.

How do regulators decide which banks go in which categories? A combination of factors includes regulators’ judgments on how important the bank is to other banks, the degree of a bank’s cross-border business, its own sources of capital, and the risk of the bank’s portfolio of assets.

In fact, all of the Basel III core capital ratios—even the starting 7%—are adjusted for the degree of risk in a bank’s portfolio of assets.

And this is where Basel III turns into a rescue plan for central bank balance sheets.

The riskier a bank’s portfolio is, the more capital it will have to raise. Capital isn’t cheap for banks right now, because the financial markets don’t much like the effect of changes in bank regulation on future profits.

The more capital a bank has to raise, the lower its return on capital is likely to be. And the less investors will pay for its stock.

But as we all should remember from the global financial crisis—when AAA-rated mortgage-backed securities suddenly turned out to be extremely risky—judging the risk of a portfolio asset isn’t totally objective. And in their regulations on risk, Basel III regulators have decided—so far at least—that government debt securities will remain, as traditionally, risk-free.

Yep, despite:

  • the fact that debt-rating companies have warned that they’ve got an eye out for a possible downgrade on US and UK debt;
  • and recent, even stronger warnings on Italy and Spain;
  • and multiple downgrades for Greece, Ireland, and Portugal...

Despite all this, under Basel III, a bank that holds sovereign debt won’t be required to adjust its core capital ratio higher to make up for any extra risk.

NEXT: Buying Assets to Lower Risk

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Buying Assets to Lower Risk
Let’s leave the question of just how smart this decision is aside for the moment, and look at its effects.

Let’s say a bank wants to lower the amount of core capital it has to raise to meet Basel III rules, instead of paying the price to raise more capital or taking the hit that more capital would bring to the bank’s return on capital.

It could, of course, shrink its balance sheet by selling off assets. There’s probably not exactly a rip-roaring market for the kind of assets it would most like to sell—those with high risk, according to regulators. Selling would trigger a write-down in many cases, because banks haven’t marked down the price of many riskier assets to market values.

Or the bank can lower the risk on its balance sheet by buying and holding assets judged risk-free by Basel III regulators. There is plenty of sovereign debt to go around these days, so it’s not hard to buy as much as you want.

And while the less risky of this sovereign debt doesn’t yield much, it’s not like these banks are turning away more lucrative commercial loans. Deposits at US banks exceeded loans by a record $1.45 trillion in May, according to the Federal Reserve. (In the ten years before the financial crisis in 2008, loans exceeded deposits by an average of $100 billion.)

As long as the lending market remains in its current near-comatose state, buying sovereign debt seems like a no-brainer.

How big could the bank appetite for Treasuries be? It’s already quite healthy. Banks have increased their holdings of Treasuries and other government-related debt to $1.68 trillion in May, from $1.08 trillion in early 2008, according to Bloomberg.

Barclays Capital estimates that Basel III calculations of risk could reduce core capital ratios for the median US bank by 3 percentage points. If banks were to make up that core-capital-ratio shortfall strictly by raising capital, they’d have to raise about $250 billion in new capital, Barclays calculates. Adding Treasuries to a portfolio would reduce the need for new capital.

I’d say that the appetite for Treasuries from US banks would be enough to pick up a great deal of slack from the end of QE2.

But remember, we’re not talking about a problem for just US banks. Basel III is a set of global rules, and banks everywhere face the same challenge of higher core capital ratios. So you’ll see banks in the Eurozone, Japan, and the United Kingdom buying Treasuries right alongside their US counterparts.

And they’ll be buying the sovereign debt of Japan, the United Kingdom, France, Italy, and Spain, too, as long as the final Basel III rules and regulations give a thumbs-up to the concept of risk-free sovereign debt. This is a huge boon to the central banks of the United Kingdom and Japan—which have both expanded their balance sheets in the fight to stabilize their own banking systems and economies.

At one further remove, it will be a boon to the European Central Bank, which will be able to garner more support for its own expanded balance sheet from Eurozone central banks. The ECB relies on contributions from Eurozone member states for its funding.

So far, the Eurozone doesn’t issue its own common debt, but I think the Greek crisis and Basel III are likely to push the monetary union toward some kind of euro bond.

Not All Good News
The dangers in this “solution” should be clear to anyone who has been following the Greek debt crisis:

First, it’s not really a solution. It merely kicks the problem down the road (as the proposed Greek “solution” would do), with a hope that better economic conditions in the future will provide an actual solution.

Second, it involves exactly the same kind of debt-rating deception that was at the heart of the US mortgage-backed securities collapse, and that contributed to the Greek debt crisis. Calling sovereign debt risk-free, and incentivizing banks to buy this debt, exposes them to potentially crippling losses if the debt turns out not to be risk-free.

I think it’s naive to assume that banks will resist such incentives. They certainly didn’t resist the incentives of higher yields and AAA ratings in the run-up to the mortgage-backed securities collapse.

Third, this “solution” comes with a built-in time limit. Banks will find the minimal yields of US Treasuries attractive only as long as the loan market remains in the tank.

When loan demand picks up, the Treasury market is likely to see increased selling by banks eager to get back into the banking business. That could accelerate the pace at which Treasury prices fall and yields climb in any US economic recovery.

In short, Basel III may rescue the Treasury market in the short term, but it’s also another reason to worry...if not about 2011, then about 2013.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Home Inns and Hotels Management and Mindray as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.